Business Model of Geo Energy
Geo Energy (SGX Stock Ticker RE4) is a coal producer established in 2008 and listed on the Singapore Stock Exchange’s main board in 2012. It owns several coal mines over 17,000 hectares and has almost 100 million tonnes of coal reserves. After its IPO, Geo Energy was mired in years of unprofitability as coal prices nosedived from the highs experienced in 2010. Long-time shareholders have suffered as a result. Oh yes, you can count Jim Rogers as one of them too. Jim Rogers became a Geo Energy board of director since December 2012. In 2015, the board appointed a new CEO. It marked the start of a dramatic turnaround for Geo Energy as indicated in its 2016 annual report. The new CEO has rationalized a new and scalable business model for Geo Energy as shown below.
1. As a coal producer, Geo Energy is granted a concession by the host government to develop and extract coal from a defined area for a number of years. There is usually an expiry date to the concession license.
2. As the asset owner, Geo Energy outsources the actual mining work of overburden removal, coal haulage services to PT Bukit Makmur Mandiri Utama (BUMA). PT BUMA uses its dump trucks to excavate the coal from the mine and transports them to the port where they are crushed into smaller pieces.
3. Afterwards, the crushed coal is loaded onto barges and transported to the client by sea.
4. For Geo Energy’s main asset, the Sungai Danua Jaya (SDJ) mine, the “client” refers to Engelhart Commodities Trading Partners (ETCP). ECTP has executed an offtake agreement with Geo Energy for the lifetime production of SDJ mine. ECTP will prepay Geo Energy for the coal even before they are mined and transported. This is extremely positive for the cashflow of Geo Energy! ECTP would in turn sell these coal to end users in China, India etc.
Having provided a simple description of the business model of Geo Energy, let’s examine its investment merits.
Investment Merits of Geo Energy
1. Solid track record
Ever since Mr Tung Kum Hon, the current CEO, was appointed in November 2015, he has totally transformed the company. He has instructed the disposal of the mining services and coal haulage service business units. As a result, this generated cost-savings of USD 1.7 million in operating expenses per quarter. It also allowed Geo Energy to operate with a lower capital expenditure and become a cost- competitive coal producer. Aided with higher coal prices, his stint at the company coincided with a return to profitability. The revenue and profit has improved significantly since 4Q2015. As shown below, except for a rain-disrupted production period in 2Q2017, the revenue and net profit has improved every quarter. To Heartland Boy, this is an indication that Geo Energy is on a turnaround. While 6 quarters of improvement may not be indicative of a consistent track record, it could suggest that this is the start of something remarkable for Geo Energy. As such, Heartland Boy is taking a measured risk by taking up a small position first.
2.Reversal to A High ROE
Consistent with a turnaround company, both its ROA (Return on Asset) and ROE (Return on Equity) are negative in Years 2014 and 2015. However, as it achieves profitability in Year 2016, its ROE and ROA reached 17.8% and 7.7% respectively. These are returns high enough to clear the hurdles that Heartland Boy has established for these 2 metrics. If the management can replicate what it has achieved in 2016 for 2017 and 2018, it would have demonstrated a consistent track record of a high ROE and high ROA.
3. Debt Situation
As the net operating cashflow of Geo Energy improves over the last 2 years, it has managed to grow its cash position. As at 2Q2017, it has a net debt of USD 22 million. (Cash and Bank Balances + Deposits and Prepayments – Finance Leases and Notes Payable). USD 22 million of net debt is a manageable amount and represents the entire net earnings of 2016 and could easily be repaid with a couple of quarters’ operating cashflow.
Do note that on 5 October 2017, Geo Energy successfully issued USD 300 million senior notes due in 2022 with a coupon payment of 8%. Part of the proceeds raised has been used to do an early redemption of the initial bond (USD 100 million, 7% coupon) that was due on January 2018. Although the Notes raised was significantly larger than the amount required to redeem the initial Geo Energy bond, Heartland Boy interprets this as confidence from the broader market about 2 issues:
- The production capability of Geo Energy’s current assets (signals ability to generate the required cashflow to repay the latest bond)
- Management’s ability to find future Net Present Value (‘NPV’) positive projects with the enlarged warchest.
Do note that while Management is looking for the next NPV-positive project, its annual financing cost will increase by more than 3 times. (USD 24 million per annum compared to USD 7 million per annum). The clock is already ticking.
4. First Dividend Declared
At its Full Year 2016 results announcement, Geo Energy declared its maiden dividend of $0.01 per share. This is a good sign that the company is committed to delivering returns to shareholders. Geo Energy share price at time of article was $0.28 and therefore it sports a trailing dividend yield of 3.6%. With 2017 likely to outperform 2016, Heartland Boy hopes that the dividend can be increased.
5. Sustainable Competitive Advantage
While the quality of coal that Geo Energy produces is nothing extraordinary to shout about, it does have a sustainable competitive advantage in terms of its cost of production. The SDJ mine is strategically located 17km away from the jetty and 15km to anchorage. As a result, the logistics costs are significantly reduced. Analysts guided that the average cost of production for SDJ mine over its lifetime would be USD 26/ tonne. The diagram shows how it has managed to keep its cash cost rather stable at a range of USD 21 – 25 per tonne. This provides a reasonable buffer should coal price starts to decline.
6. Good Growth Story
Tanah Bumbu Resources (‘TBR’) mine is set to lead the next leg of growth for Geo Energy. TBR mine was acquired in June 2017. It is adjacent to SDJ and shares similar characteristics. Such familiarity is an advantage to the coal engineers and the cash cost would likely be similar or even lower as a result of economies of scale. Based on the news announcement in October 2017, PT BUMA (also the same mining services provider for SDJ) has signed a Letter of Intent to provide mining services. Geo Energy is also in the process of evaluating several offtakers for the coal produced from TBR. On an optimistic level, production can commence in 1Q2018 and propel the company to produce and sell greater coal volumes.
On a macro-economic level, demand for coal as a source of energy remains strong. Indonesia, India and China will continue to consume coal to power their respective economies.
7. Low P/E compared to peers
Geo Energy has repeatedly reiterated in its corporate presentation slides that its shares are trading at a lower Price to Earning ratio compared to its peers in the coal industry. An example would be the SGX corporate slides released in October 2017 as shown below.
When pegged against comparables such as Resource Alam Indonesia Tbk and Harum Energy Tbk, it does seem to indicate that Geo Energy is undervalued from the P/E perspective.
8. Intrinsic Value is Higher Than Current Stock Price
To estimate the intrinsic value of Geo Energy, Heartland Boy made use of the 1P (Proven) resources of SDJ, TBR and BEK coal mines. With the simple assumptions shown below, it will generate a Net Debt NPV of USD 551.9 million dollars.
At his entry price of 28 cents per share, which equates to USD 274 million, there is reasonable margin of safety for Heartland Boy. This also implies that the break-even cash profit per tonne for Heartland Boy’s entry price would be $5. With an average cash cost of USD 23.50 per tonne in the last 6 quarters, the break-even realized price would be approximately USD 28.50 per tonne. When coal bottomed in early 2016, the Indonesian Coal Reference Ecocoal 4200 kcal Index did dip to such levels though.
Investment Risks of Geo Energy
1. Government Policies
The biggest risk to Geo Energy would be the coal policies of the respective governments. As the biggest consumer of coal, China’s policy on coal would have a very direct impact on Geo Energy. This is especially since most of the coal under ETCP’s offtake agreement eventually ends up at China. Recently, China has shut down polluting domestic mines in order to achieve a less polluted environment. A decrease in domestic production would have to be replaced by more imports and so this is positive for Geo Energy at the moment.
Likewise, as the host country of Geo Energy’s mines, what Indonesia does with its coal policy would directly impact Geo Energy. Recently, there has been market rumours that the Indonesia government is seeking to implement a minimum domestic market obligation rule for coal mines in Indonesia. If this is indeed effected, Geo Energy may be forced to sell more of its coal to the domestic market on a “cost-plus margin basis”. As a result, its profits margins may erode. Therefore, it is imperative that any shareholder of Geo Energy keeps tracks of news about coal policies in China and Indonesia.
2. Volatility of Coal Price
As a coal producer, Geo Energy is fully exposed to the vagaries of coal prices. As a commodity, Geo Energy is a price taker with no influence on the market price. Therefore, Geo Energy can be seen as a proxy to coal prices. Well, investors can at least be comforted by the fact that Geo Energy still managed to eke out a $3/tonne cash profit even when coal prices bottomed at USD24/tonne in 1Q2016. Heartland Boy will be monitoring the Indonesian Coal Price Reference (HBA) here. Those with subscription to Bloomberg can follow the Indonesian Coal Reference Price Index.
Conclusion of Geo Energy
Heartland Boy has a personal price target of $0.56 for Geo Energy. Various analysts such as PhillipCapital and KGI have target prices of 44 cents 36 cents respectively for Geo Energy. In addition, special mention to fellow blogger Thumbtack Investor who has always patiently replied Heartland Boy’s queries on Investing Note.
Vested at an average stock price of 28 cents since October 2017
This article is published on 27 October 2017.